Does Apple's P/E mean it must trade higher?

ChrisKacher & Gil Morales

Chris Kacher and Gil Morales are managing directors of MoKa Investors LLC
and co-founders of
Virtue of Selfish Investing. Both were senior portfolio
managers at William O’Neil + Co. They co-authored the book "Trade Like an
O’Neil Disciple: How We Made 18,000% in the Stock Market." Kacher received his
B.S. in chemistry and Ph.D. in nuclear physics from the University of California
at Berkeley, where he studied under Nobel laureate Glenn Seaborg and
helped to discover Element 110 on the Period Table of Elements and to confirm
Element 106.

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The current debate over whether Apple is a "bargain" stock rages on in light of its often cited and allegedly "low" price-to-earnings ratio (P/E) after declining 28.3% from peak to trough off of its all-time high of 705.07. In our view, this is a flawed analysis, and those who have purchased Apple stock above the $600 price level on the way down after it peaked in mid-September 2012 have so far paid a price, both financially and emotionally.

Financially, because they are underwater on their purchase of Apple shares, and emotionally, because they have had to watch the stock plummet to a low of 505.75 before staging any kind of reaction rally and bounce. And all because they insist on relying solely on P/E ratios to assess the soundness of their decision to purchase Apple shares while in the midst of a "falling knife" downtrend.

"I'm not smart. I try to observe. Millions saw the apple fall but Newton was the one who asked, "Why?"
—Bernard Baruch

Let's be clear from the start, we have no stake in any rigid view of where Apple stock "should" be trading. If we believe Apple is going higher, we will buy the stock; if we believe it is going lower, we will short the stock. None of this has anything to do with personal opinions — it is based entirely on observing the price/volume action of the stock and thereby using the market's intelligence to identify the likely ensuing price trend.

But first, let's review the P/E question within the context of Apple's overall trend. Since 2004, Apple has posted annual earnings growth of 310%, 246%, 60%, 73%, 73%, 34%, 67%, 83% and 60%, according to data from William O'Neil + Company, Inc. This is a very strong nine-year annual earnings record that included one contraction in 2009 to 34% followed by a resumption of high-double-digit earnings growth peaking at 83% in 2011. During this period Apple's stock price went from roughly $12 to over $700 a share.

According to First Call, analysts' estimates for the next five years in sequence show annual earnings growth of 12%, 18%, 16%, 8% and 14%. It does not take extraordinary powers of observation to see that the pattern and trend of Apple earnings growth is set to diminish rapidly, and in fact, next quarter is expected to show -3% earnings growth on a quarter-over-quarter basis, e.g., comparing the $13.30 estimate for next quarter to the $13.87 in earnings that Apple posted in the same quarter one year ago.

Currently Apple sells for 12 times forward 12-month earnings. In 2004, Apple's P/E ranged from 38-56, clearly not a "cheap" P/E ratio. But that is the point from which Apple began its huge price run from 2004 to 2012 that took it from $12 to $700 a share, yet it was also when Apple was most "expensive" in terms of P/E ratio. In that case, in 2004, should one have concluded that Apple stock was "too expensive" to buy at that time? Of course not, because the market was placing a high value on Apple's future earnings stream, which the market's "macro-mind" was able to perceive well before it became obvious to the crowd.

In fact, Apple's massive nine-year price move began with a very discernible technical buy signal that we refer to as a "Buyable Gap Up" that occurred after it announced earnings in October 2004, and at the time, Apple's P/E ratio was an "expensive" 45.

Chart 1, the nine-year weekly chart, shown below, tells the story. Based on the future potential price appreciation at the time, Apple was the "cheapest" when it was selling at 45 times earnings in 2004, and that is an observable, objective fact.

Therefore, we can quite simply conclude that trying to pin some sort of strict and rigid "P/E analysis" to Apple's status as a "cheap" or "expensive" stock is not borne out by market history and market facts. P/E ratios do little more than tell you what value the market places on any company's future earnings stream. Unless you are arrogant enough to think you are smarter than the market, than the odds are that you will pay the price again and again for relying on such analysis in assessing the soundness of your personal portfolio's stock purchases.

When viewed in a short time-frame, we can begin to understand what is going on with Apple right now with respect to its essential price/volume action. After failing to hold the $700 price level Apple quickly reversed course and declined for eight straight weeks with several short-term sell signals interspersed along the way. Once the stock undercut the 522.18 lows of the prior consolidation it formed from April through August 2012, as we predicted it might in our previous blog post on the stock, the crowd likely saw this as a breach of support, bringing in late short-sellers and washing out the last of the sellers, at least in the short-term.

This has led to a two- to three-week bounce off the lows that see the stock moving up toward its 10-week and 40-week simple moving averages, the blue and red lines on the weekly chart below, respectively, where it appears to be stalling out as weekly volume increases.

Notice also that the 10-week line has just crossed below the 40-week line, resulting in a bearish "black cross." While at the time of this writing we do not see any technical short-sell signal just yet, we do note that the bounce appears quite normal within the context of the stock's prior downside move off the peak, and it is finding resistance at the confluence of the 10-week and 40-week moving averages.

Has Apple topped for good? We think that there is a reasonable probability that this is so, given the available technical (price/volume) action and evidence so far, but Apple is a dynamic, innovative company, and there is always the possibility that it can re-invent itself once again with even newer and more innovative products. We do not discount Apple's product-development prowess in this regard, but so far, that is not showing up in the technical evidence, which appears to argue for further downside, perhaps even a retest of the recent 505 lows.

Our conclusion is that, at best, investors should take a wait-and-see approach before jumping into Apple shares at the current price, since we do not believe that the stock necessarily has a "right" to trade higher on the basis of a low P/E ratio.

What will it take for Apple to turn around and sustain a bold, new price uptrend? Clearly, as with any other leading-edge growth stock, it will take a resumption of strong annual and quarterly earnings growth. And what will the first signs of such a critical fundamental development? The market's "macro-mind" will likely figure it out first, and it may initially take the form of a strong technical buy signal coupled with a high P/E as the market again begins to place a high value on Apple's future earnings stream. If and when the technical evidence emerges to support such a development, we will be more than happy to be aggressive buyers of the stock. For now, caution is advised.

Disclosure: Mr. Morales and Mr. Kacher are short Apple.

Gil Morales and Dr. Chris Kacher are both principals and managing directors of MoKa Investors LLC and Virtue of Selfish Investing, LLC, cofounders ofand co-authors of "Trade Like An O'Neil Disciple: How We Made 18,000% in the Stock Market" (Wiley, August, 2010). Both are former internal portfolio managers for William O'Neil + Co., Inc., where Dr. Kacher also served as a research analyst and Mr. Morales also served as Chief Market Strategist, Vice-President and Manager of the firm's Institutional Services group, and co-authored with William J. O'Neil a book on short-selling, "How to Make Money Selling Stocks Short" (Wiley, 2004).

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